As Greenland moves away from Denmark and acquires more autonomy, this column asks whether it might be too small. In assessing the relationship between country size and economic performance, it warns that small states have more volatile GDP, more volatile consumption, and more incompetent civil servants.

Greenland’s population of about 60,000 make it as about the same size as Bismarck, North Dakota. It is blessed with natural resources such as rich deposits of minerals, and oil and gas reserves are believed to lie below its ice cap. It is protective of both its fishing industry and its long tradition of killing appealing marine mammals. Greenlandic, an Eskimo-Aleut language, is spoken by few outside its borders.

On 1 May 1979, this miniscule country began its move toward autonomy when the Danish parliament granted Greenland home rule. Greenland swiftly distanced itself from Europe by exiting the EU in 1985 – the only country ever to have done so. The goal was to avoid the EU’s Common Fishery Policy (the ban on seal skin products also played a role). Greenlanders approved a referendum on greater autonomy on 25 November 2008 and on 21 Jun 2009 Greenland expanded its sovereignty by assuming authority over its judiciary, policing, and natural resources, leaving only finances and foreign affairs in Danish hands. The Danish queen attended a celebration at the parliament in Nuuk, and Greenlandic became the country’s official language.

Can a country be too small?

Although it is not yet heavily involved in international banking, Greenland’s progression toward independent statehood is strikingly reminiscent of Iceland’s experience (especially its desire to maintain its own culture and protect its natural resources at the cost of isolation from the rest of the world and its wish to limit its economic relationship with Europe). This raises questions – does the recent experience of Iceland suggest that a country can be too small to be a nation state, and what are the costs and benefits of being isolated from the rest of the world?

The answer to these questions is relevant not only for Iceland and Greenland but also other tiny countries that have gained sovereignty in recent decades; since 1990, 33 new countries have been formed and, as seen in Figure 1, many are very small.1

Figure 1. Country size (population in millions)

In this column, I argue that there is little economic justification for preferring small size and that there can be significant costs. I also argue that Iceland’s small size was probably a key factor in Iceland’s failure to stop its financial crisis.

Do smaller countries enact better economic policies and grow faster?

It is usually claimed that the benefit to small size is social homogeneity which leads to cohesion and an ability to build a consensus. This may promote flexibility in the face of changing circumstances and make it easier to enact policies that promote growth. Indeed, some small economies such as New Zealand, and, in many respects, Iceland are widely viewed as paragons of economic virtue. Formal empirical evidence linking small size to growth-promoting policies appears to be lacking, however. Easterly and Levine (1997) find a strong negative correlation between ethnic diversity and indicators of growth-promoting public goods such as the number of telephones and paved roads and the amount of schooling. However, Easterly and Kraay (1999) assert that a lack of consistent data makes it hard to test whether small size is associated with growth-promoting public goods.

While many small economies have grown rapidly, the existing empirical literature finds that the effect of country size on growth is inconclusive. Easterly and Kraay (1999) find that, after controlling for location, small states are wealthier than large states but do not have significantly different growth rates. This may be because country size has an insignificant effect on growth or it may be due to limited data; there is a lack of consistent data sets that include a large number of small countries. See Armstrong and Read (2002) for a discussion of this literature.

Smaller countries have more volatile output

The recent experience of Iceland suggests that, while there is no clear evidence that small countries experience higher average growth rates, they do have more volatile growth rates. As shown in Figure 2 below, Iceland’s output growth is less smooth than that of either the UK or the US. The reason for this seems clear. As a small country, Iceland is far less diversified in endowments and production than the much larger UK or US. A shock in the aluminium, fishing, or banking sector has a major effect on Icelandic output; shocks to different sectors in much larger economies tend to average out.

Figure 2. Percentage change in GDP at constant prices

Smaller countries have more volatile consumption

Output volatility is not necessarily costly; countries care about smoothing consumption, not output. Residents of a country with variable output can smooth their consumption across states of nature by holding a diversified portfolio of home and foreign equity. However, most countries hold relatively small amounts of net foreign assets. In addition, such risk sharing is partial at best if it is not possible to hedge against adverse shocks to the return to human capital.

If shocks to a country’s output were purely transitory, a country could use its current account to smooth its consumption – borrowing in states where output is low and lending in states where it is high. Unfortunately, from the point-of-view of smoothing consumption, most shocks appear to have a large permanent component. Thus, it seems likely that a country with relatively variable output will have relatively variable consumption as well.

In a study of 56 countries over the period 1950 – 1985, Head (1995) finds that the variances of both output growth and consumption growth are indeed negatively correlated with population size. Moreover, this effect is especially pronounced in high-income countries. Figure 3 shows the relationship between population size and (detrended) consumption volatility for 20 relatively high-income countries. While some small countries have very low consumption volatility (Norway, Luxembourg), many have very high volatility (New Zealand, Trinidad and Tobago, and Iceland).2

Other problems in small countries

A small population has other costs; I will mention three here. First, as the provision of many public goods has an important fixed cost component, the per capita cost of public good provision is likely decreasing in country size. Second, it is also likely that the per capita administrative cost of income taxes is decreasing in country size. As a result, smaller countries tend to rely less on relatively efficient income taxation and more on relatively inefficient taxes, such as customs taxes (see Easterly and Rebelo 1993). Third, a lack of competition in the provision of non-traded goods in small countries can lead to inefficiency.

I have focused on costs associated with small populations, but there is also an important cost associated with small geographical size. Many countries are vulnerable to natural disasters and environmental damage and self-insurance against these sorts of shocks is easier for larger countries. If an American city is damaged by a hurricane, residents can move to another American city. If global warming causes sea levels to rise sufficiently, the consequences for the residents of Tuvalu are likely to be less favourable.

Problems for civil servants in small economies

In October 2005, David Oddsson was appointed chairman of the board of governors of the Icelandic central bank. The multi-talented Oddsson had studied law, been a theatre director, the producer of a comedy radio show, a political commentator, and the co-author of several plays. He had previously been the mayor of Reykjavik, a long-time prime minister and, for a brief period, the foreign minister. Unfortunately, he appears to have had no expertise in economics and banking and was ineffective at either averting the financial crisis or playing a positive role in its aftermath.

In addition to Oddson’s apparent acquiescence in the face of looming disaster, neither the prime minister, nor the finance minister or financial regulator seems to have made any serious attempt to stem the growth of the Icelandic banks. This suggests that a significant cost of small size is the burden that it places on senior government officials.

Despite its miniscule size, Iceland has ministries of business affairs, communications, science and culture, environment, finance, fisheries and agriculture, foreign affairs, health, industry and tourism, justice and ecclesiastical affairs, social affairs, and social security. This causes two problems. First, it is difficult for such a small country to find enough talented civil servants, and second, each civil servant is forced to play more roles than he would in a more populous society. Such multi-tasking can be demanding and makes it difficult to build up expertise in a particular area.

In an interesting article, Farrugia (1993) suggests that very small countries may also suffer because of their high degree of interpersonal relations. In a tiny nation, everyone knows everyone. This can facilitate things getting done quickly, but it has its costs. Farrugia comments that, “Many necessary decisions and actions can be modified, adjusted and sometimes totally neutralised by personal interventions and community pressures. In extreme cases, close personal and family connections lead to nepotism and corruption.”

In Iceland, it has been alleged that personal animosity may have played a role in the central bank denying Glitnir a loan in October 2008 and that the Independence Party played an unseemly role in the privatisation of Landsbanki with agreements made to offer plum executive positions to Independence Party members. Even if such suspicions are untrue, the widely held belief that they might be is damaging to social cohesion and the state’s legitimacy.3

A sensible policy solution to the problem of filling sufficiently important posts when there is limited local talent or to filling a politically sensitive post where the independence and impartiality that is required cannot be found at home is to hire foreigners. Prime Minister Johanna Sigurdardottir has already adopted this strategy by hiring a Norwegian expert to be the acting central bank governor and a Norwegian-born French magistrate to investigate the possibility of criminal activities by Icelandic banks. In the long run, if supervising the banking system requires more expertise than can be acquired locally, Iceland should hire supervisors from abroad – the banks can be taxed to fund them.

Island officials should get out more

Many very small countries are islands, and thus isolated. It is more difficult for senior officials to travel to a neighbouring country if they live on a remote island than if they live in Luxembourg. This leads to a danger that policymakers in small and far away locations might become insular in their thinking and that they might not have access to advice that their counterparts abroad might offer. It is thus important that senior officials in out-of-the-way locations make an attempt to attend conferences and other professional gatherings abroad.